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FX Week Ahead - Elections, Repatriation, US, UK Data

Over the past week, we have seen the drama in the foreign exchange market subside. Greece no longer poses an imminent threat to risk appetite and even though there are lingering concerns about Spain, Portugal and other debt stricken European nations, investors are taking their troubles in stride. The lack of fresh market moving news out of Europe made this week a quieter one but with a heavy economic calendar and a number of central bank officials speaking, there are a few important takeaways that could affect how the dollar and other currencies behave:

#2 - The resolution to the Greek crisis single handedly changed the outlook for central banks around the world

#3 - The dollar is overbought and taking its cue from U.S. yields

#4 - Cheap money is fueling the rise in equities

The two most important things that the Federal Reserve said this week was that oil and gas prices would only have a temporary impact on inflation and the recovery is still frustratingly slow. This indicates that even though there have been improvements in the U.S. economy, the pace is not strong enough for the Fed to even think about changing their game plan for monetary policy. Yes, they have grown less willing to raise stimulus but at the same time, they have not grown more willing to raise interest rates and this is where the market got it all wrong. U.S. yields are up significantly since the beginning of the month and interest rate expectations increased along with it. The market is currently pricing in a full 25bp rate hike from the Fed in September 2013, one year earlier than the central bank’s projections. Expectations were so distorted that at one point Fed Fund futures were pricing in a 50 percent chance of a rate hike this year. Investors finally heard what the Fed said after the surprise miss in core CPI growth made them realize that consumption and inflation are being heavily distorted by higher energy prices. At the same time, the dollar has become extremely overbought and a pullback is natural. The same is true for equities – cheap money has fueled the gain in the stocks but the possibility of no additional easing from central banks has put the brakes on the rally. Yet central banks have still found a cause for optimism. Everyone from the Federal Reserve to the Bank of Japan and the Bank of Canada have said the downside risks to global growth has receded and the main reason is because the Greek default did not trigger a sharp sell-off in the financial markets.

Although there are many U.S. and Eurozone economic reports on the calendar next week, they should not have any significant impact on volatility except perhaps the Eurozone PMI numbers. Most of the U.S. economic data will be related to the housing market and we already know that housing demand is weak. Instead, U.S. yields and U.S. equities will be main driver of market flows and risk appetite. Elections in Germany and Greece will be worth watching although at this point, the outcome probably won’t matter to investors. As we near the fiscal year end in Japan, repatriation could have a larger impact on the Yen. With the rally in USD/JPY losing momentum, Japanese companies may feel compelled to take advantage of the yen’s latest weakness to repatriate their foreign profits. If the yen starts to rise, their foreign profits will be worth less when converted back into yen and this fear could motivate profit taking in the coming week. Finally, while we don’t have much market moving U.S. data., we have a tremendous amount of important economic reports from the U.K., which we will cover in more detail in the sterling component of our commentary.

EUR: SPECULATORS CUT SHORT POSITIONS

The euro broke out of its two day consolidation to trade sharply higher against the U.S. dollar. Today’s rally in the EUR/USD was the strongest in 5 trading days and the lack of any major catalysts suggest that this could be related to profit taking or short covering. According to the CFTC’s latest commitment of traders report, short euro positions were trimmed significantly over the past week. While we still believe that EUR/USD could be vulnerable to additional losses, it is clear that a fresh catalyst is needed for that to happen. The rally in the EUR/USD today was sparked by weaker core consumer price growth in the U.S. but reports that the European Financial Stability Facility and the European Stability Mechanism could be increased by 40 percent also lent support to the euro. According to a senior euro zone official, one possibility is "the combined lending capacity would go from 500 billion to roughly 700 billion." This amount is still considered too small but any larger commitments have been opposed by the Germans. We have long believed that if push comes to shove, European nations will be committing the minimum and not the maximum to the rescue fund - its like getting money from Uncle Scrooge. In the meantime, as long as Portuguese, Italian and Spanish yields hold steady, the impact of Europe's sovereign debt crisis on the euro will continue to dissipate. The most important set of economic data from the Eurozone next week will be the PMI reports. If economic activity in the service and manufacturing sectors continue to expand, it will alleviate the concern about a deeper slowdown for Europe the second half of the year. If the data is weak, then the EUR/USD could reverse its gains and take a stab at 1.30.

GBP: BUSY WEEK AHEAD

The British pound traded sharply higher against the U.S. dollar today in anticipation of next week’s economic developments. It will be an extremely busy week in the U.K. with the Budget announcement and Bank of England minutes scheduled for release. We also have consumer prices and retail sales on the calendar. The recent rise in inflation is expected to make monetary policy committee members wary of increasing stimulus. We expect the CPI numbers to show an uptick in price pressures. Retail sales on the other hand may not be as strong with confidence remaining weak and the labor market deteriorating. According to the British Retail Consortium, consumer spending fell for the second month in a row. Unlike the U.S. where we have seen consistent improvements in most economic reports, U.K. data has been mixed. Unfortunately there is still enough weakness that the Monetary Policy Committee will be leaning towards more and not less stimulus. As for the Budget we don’t expect new measures to have much impact on the deficit. Chancellor Osborne needs to balance efforts aimed towards stimulating the economy with his aggressive plan to reduce their budget deficit. So far the U.K. government has done a good enough job that they will be able to pat themselves on the back next week and say that they borrowed less in the 2011/2012 fiscal year than expected.

AUD: RBA MEMBER WORRIED ABOUT LABOR MARKET

All three of the commodity currencies were lifted by the weakness of the U.S. dollar. While USD/CAD remains in a close trading range, both Australian and New Zealand dollars continued to climb back from their one-month lows against the greenback. While the mining engine has kept the Australian economy charging forward, the employment outlook remains more pessimistic. The head of the Australian Industry Group and a board member of the nation’s central bank, Heather Ridout, warned of a weakening labor market. "The labour market continues to soften, with employment falling and unemployment and underemployment rising," she said in the statement. The RBA meeting minutes due out on Tuesday could also present similar rhetoric on the economy. Also from Australia, the leading index on Wednesday could highlight more weakness in the economy as well. The item to watch from New Zealand will be the fourth quarter GDP on Thursday. Despite the improvement in retail trade and construction sectors, manufacturing has been slowing. The market and the central bank both forecasted a 0.6 percent growth in the fourth quarter. We also have Westpac consumer sentiment on Monday and current account on Wednesday. In Canada, the latest data shows that the manufacturing sectors are struggling to regain footing. The manufacturing sales declined 0.9 percent in January dragging down by aerospace sector. Moreover, the job market has stumbled since the middle of last year. Nonetheless, as the US economy rebounds, we could see a stronger recovery in Canada.

JPY: BOJ MINUTES SHOW INFLATION TARGET DEBATE

As the Japanese yen pared back some of its weekly losses against the US and Canadian dollars today, the yen continued to decline against the rest of the major currencies. The only release from Japan was the meeting minutes from the Bank of Japan. The February minutes highlighted the central bank’s discussion about their inflation target. Some members of the board suggested that the bank could take this opportunity to change the numerical expression to one that took account of the possibility that the inflation rate the bank should aim to achieve could surpass 1% in the longer run," the minutes said. Some members also expressed the view that the central bank should be more effective in communicating its active stance in fighting deflation. Moreover, the minutes clarified the bank’s latest action to provide additional stimulus was not to monetize government’s debt. The bank governor Masaaki Shirakawa said Feb. 14 that the central bank will “never buy bonds to help finance” the government, and that to do so would erode trust in Japan’s debt. Looking forward to next week, we have industries activity on Wednesday and trade data on Thursday. While the market expects a 0.34 trillion deficit on Thursday, the weakness in yen could slightly ease the pressure on exporters. Nonetheless, rising energy prices could remain a headwind for the Japanese economy as the country relies heavily on importing crude oil and gas.

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